January 1999 Hot Topics

Joe Cobal worked as a computer programmer for several years when a Silicon Valley headhunter approached him: "How'd you like a job with Start-Up (an Internet start-up company)? Start-Up can't pay you a large salary, but you'll receive stock options." Intrigued, Joe quit his job and moved to Silicon Valley and began working for Start-Up on January 1, 1994. Joe’s salary was 70% of his former earnings, but he also received the prized perk: For each year (12-month period) he worked, Joe would receive an option to purchase 50,000 shares of Start-Up, at a penny ($.01) per share. Each option would expire 10 years later. The company's current stock value was ten cents ($.10) a share, but was not publicly traded. The options had no other restrictions.

Joe worked for three years and received his stock options on December 31^st of each year. On January 2, 1997, Public, a publicly-traded company bought Start-Up, paying $20.00 a share. Was Joe an instant millionaire? Answer the following questions:

If Joe exercises his options prudently, upon his sale of Start-Up stock Joe will receive: (a) $50,000; (b) $150,000; (c) $3,000,000? The price Joe will pay to exercise his options is: (a) $5,000; (b) $15,000; or (c) $1,500? If you chose (c) for both answers, you understand why, in Silicon Valley and elsewhere, stock options are the '90's equivalent of the California gold rush.

Joe could receive as much as $3,000,000 by exercising options at a cost of $1,500, however, his tax consequences must be examined. The balance of this article will discuss how stock options work and how they are taxed.

Stock Options in General

Stock options have been used for many years by investors. A stock option is, basically, the right to buy a fixed number of shares of stock for a set price (the "strike" price) during a specific period of time; i.e., Joe's right to buy 50,000 shares of Start-up common stock at $.01 (a penny) a share until January 31, 2005.

The difference between the strike price and the FMV of the stock is the "spread." If the spread exceeds the cost of exercising the option, then the option is "in the money." For example: Suppose you pay $2.00 for the right to purchase a share of stock at $5.00 a share for 24 months. If during the option period FMV of the stock climbs above $7.00 a share, you are in the money.

Stock Options in the Marketplace

In non-employment-related stock option transactions, the person holding the right to purchase is called the "Optionee" and the person owning the shares is called the "Optionor." The Optionor usually sells the stock option for a premium. For instance, assume an Optionor holds 1,000 shares of GM stock which is trading at $95 a share. The Optionor might agree to sell the 1,000 shares at $100 a share for one year for an option price of $5,000.

The Optionor is betting the price of GM stock will increase $5.00 per share (the $5,000 option premium is equivalent to a $5/share increase), while the Optionee believes the stock price will exceed $105/share during the option period.

The tax consequences flowing from an option are based on the "option privileges." The privilege is the Optionee’s right to benefit from any increase in value of the underlying stock without being subjected to a risk of loss. Conversely, the Optionor's privilege is the right to benefit from a decrease in the underlying stock without risk of loss. The fair market value of an option has two parts: (1) the value of the option privilege and (2) the difference between the stock's value and the strike price.

The value of the option privilege depends on three main factors: (1) whether the stock has an ascertainable value; (2) the probability of the stock's value increasing or decreasing; and (3) time period for the option.

Employment-Related Stock Options

In recent years, stock options have been successfully used as an inducement to employees and independent contractors to work with a company. In this case, the Optionor is the company (Start-up), and it is not looking to make a profit on the transaction, but rather it wants to attract and retain the Optionee (Joe) to work for it.

Because options have value, receipt of an option in an employment context raises income tax issues. Is the option compensation and thus taxable immediately? Does the corporation treat the option as compensation and take an immediate deduction for the "payment" as though it paid wages?

For tax purposes, stock options are divided into "statutory" stock options which meet the Internal Revenue Code provisions 421 through 424 and all others (called "nonstatutory" stock options).

Nonstatutory Stock Options

An employee receiving a nonstatutory stock option may be taxed at any one of the following times: (1) when the option is granted; (2) when he exercises the option; (3) when he sells or disposes of the option, or (4) when the restrictions (if any) on the disposition of the stock acquired by the option lapse. In contrast, employees who receive a statutory stock option are not taxed until they sell or dispose of the stock.

Employees or independent contractors receiving nonstatutory stock options in connection with performing services are taxed at the time of receipt, if the option has a readily ascertainable fair market value (IRC Sec. 83). This rule usually applies to publicly-traded stock. Otherwise, the employee is generally taxed when the optioned stock is actually purchased (IRC Reg. 1.83-7(a)).

The value of the underlying stock over the option price is included as income when the right to exercise the option becomes "vested" (the Optionee has the right to exercise the option without restrictions). The Optionor takes a deduction for "compensation" paid to the Optionee at the time the Optionee declares the income.

Note: Under IRC Sec. 83(b), the Optionee may elect immediate taxation on the option, rather than wait until any restrictions placed on the option had lapsed. Thus, the lapse of restrictions, which is usually the point in time when the option becomes taxable, is not a taxable event. Therefore, a Sec. 83(b) election ensures that any future appreciation is not compensation and commences the holding period for long-term capital gains treatment on the disposition of the property. Also, the Optionee owns the option and his basis includes the amount paid to exercise the option and the amount taken as income by virtue of the Sec. 83(b) election.

If Joe's stock options were nonstatutory and if Start-Up's stock had a readily ascertainable value of $.10 per share, Joe would have received $4,500 in compensation upon his receipt ($5,000 FMV for Start-Up's stock, less the option price of $500 = $4,500). He should consider immediately exercising his option to acquire the actual stock, since any future appreciation in the stock will qualify for long-term capital gains treatment, maximum federal tax of 20%, provided the stock is held at least 12 months prior to sale.

If however, Joe exercised his option then sold the stock immediately to Public, he'd have ordinary income treatment on the sale and could be taxed as high as 39.6% federal. The Lesson: Ascertain whether the stock option plan is nonstatutory (read the stock option plan to determine this) and if it is, consider exercising the option at the time you must take the gain as income. This decision depends on the cost of exercising the option and whether you anticipate selling your stock 12 months later.

Statutory Options

Statutory options receive favorable tax treatment. There are two types of statutory stock option plans, incentive stock options ("ISOs") and options granted under a company’s stock purchase plan.

Generally, these options are not taxed until the employee disposes of the option and gains are treated as capital gains. If the option is held for 12 months or more, the Optionee will have long-term capital gains, taxed at a maximum of 20% federal. In contrast, the recipient of a nonstatutory stock options is ordinary income usually at the time they were granted, since the option is considered compensation for services rendered. [Note: California does not have a special rate for long-term capital gains.]

Incentive Stock Options

A most popular stock option plan involves ISOs. These are granted by a corporation (or its parent or subsidiary) to an individual in connection with employment, provided the IRS code provisions governing ISO's are met. The employee has no tax consequences from receiving or exercising an ISO and the employer receives no deduction. The option price cannot be less than the FMV of the optioned stock at the time the option of receipt and the option must be excercisable within 10 years from receipt. Also, the employee cannot own more than 10% of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies.

The employee receives long-term capital gains, provided he does not sell the stock for at least (1) two years after the option was granted; and (2) one year after exercising the option. These holding requirements are waived if the employee dies. Also, the FMV of stock subject to an exercisable ISO cannot exceed $100,000 in any one calendar year. Any excess is treated as a non-ISOs.

An employee must remained employed by the Optionor (or its parent or subsidiary) from the time the option is granted until three months before exercise. Under this rule, an employee has three months after termination of employment to exercise an ISO. For disabled employees, the post-termination period is extended to 12 months and is waived upon death.

Failure to meet the holding requirements causes the gain to be taxed as ordinary income, determined at the time the option was exercised. The gain is usually the value of the stock on date of exercise less the option price. The company is entitled to a deduction at the time the employee recognizes the income from the premature disposition.

If Joe received an ISO, then he would need to wait until the following dates to receive long-term capital gains treatment:

In our example, if Joe sold all his stock to Public on January 2, 1997 for $20/share, he’d receive LTCG treatment on 50,000 shares ($1,000,000) and 100,000 shares ($2,000,000) would be taxed as ordinary income.

Stock Purchase Plans

Under these plans, if the option price is not less than 85% of the stock’s FMV at grant, then ordinary income is generally limited to the difference between the option price and the FMV of the stock at the time of the grant. For example, suppose Joe received the right to purchase Start-Up’s stock valued at $10/share for $8.50. If he exercised his option and sold the stock for $25/share, then $1.50 a share would be ordinary income and the balance, $15/share would be capital gains.

As with ISO’s, the employee receives this tax result, provided he does not sell the stock for at least (1) two years after the option was granted; and (2) one year after exercising the option. These holding requirements are waived if the employee dies. Many of the other requirements that apply to ISO’s also apply (with minor modifications) to stock purchase plans. Employees cannot own more than 5% of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies.

The option price must be at least 85% of the stock’s FMV at either the time of receipt or exercise. Also, the option must be exercised within 27 months of receipt. This period is extended to five years if the option price is at least 85% of the stock’s FMV at the time the option is exercised. Also, no employee may receive options for more than $25,000 of stock per year, determined at the time the option is received.

Alternative Minimum Tax

The value of an ISO is included as income under the alternative minimum tax ("AMT") rules. The income amount is usually the value of the option at the time there are no restrictions on its exercise over the price paid for the ISO.

In Joe's situation, the value of Start-Up's stock over the option price, $4,500, is a positive adjustment under the AMT rules. Generally, a spread this small will not trigger the AMT. If, however, Start-Up's stock is increasing in value, Joe should exercise his stock options as soon as possible.

Assume that Joe received an ISO and at the end of the second year, Start-Up's stock was worth $1.00 a share. If Joe exercised his option to buy 50,000 shares, he could fall within the AMT ($49,500 spread). Instead, Joe elects to exercise his option as to 25,000 shares at the end of the second year and another 25,000 at the beginning of the next year. This will stretch the AMT adjustment over two years and may eliminate an AMT tax on the exercise. This strategy could backfire if the stock value continues rising, or if there is an IPO ("initial public offering") or merger with a large company.

Use IRS Form 6351 to determine your AMT exposure and what steps can be taken to lessen the AMT impact. Selling investments at a loss to offset investment gains will reduce your AMT. Also, remember that tax-free "private activity bonds" reduce your regular taxes, but do not lessen the AMT. In short, if you are received ISOs, it is important to understand the AMT consequences when you exercise them.

A Short-Hand Method to Avoid the AMT

Note: You'll need Form 1040 (regular tax) and Form 6351 (alternative minimum tax) to perform this calculation. Determine your regular tax (assume $20,000) and your alternative minimum tax (assume $15,000). Subtract the difference ($5,000) then divide the $5,000 by the AMT tax rate of 26% ($19,230). Divide the $19,320 by the Spread (assume $10) = 1,932 shares may be exercised without triggering the AMT.

Creative Tax Planning with Stock Options

Although ISO's have certain advantages, they pose an AMT risk as well as strict rules regarding the holding period for the option and the stock acquired through the exercise of the option. For small start-ups, the nonstatutory stock option may be more advantageous, especially if the spread is small and the company hopes for a huge increase in stock value in the future through an IPO or acquisition by a larger, publicly-traded company.

Estate Planning Opportunities with Nonstatutory Options

Certain nonstatutory options may be used effectively for estate planning. IRS has ruled that the transfer by the owner of nonstatutory stock options, without a readily ascertainable value, to an irrevocable trust for the benefit of his family is a completed gift. When the options become subject to tax, the owner will be taxed on the spread. This means that the trust will receive the full value without tax. There is a gift tax based on the value of the property transferred, but if the spread is non-existent or very small, little, if any, gift tax will be paid. A properly drafted trust will maximize the owner's annual gift tax exclusion, currently $10,000 ($20,000 for a husband and wife) per donee per year.

In the above example, if Joe transferred his Start-Up stock options (when the options had no readily ascertainable value) to an irrevocable trust, he would pay the tax on the when the value of the options became ascertainable (assume $4,500), but the trust would own the stock. If the trust exercised the options to obtain maximum value, then $3,000,000 would reside in the trust.

Upon Joe's death, the entire value of the trust would escape estate tax. Also, the trust provides asset protection against Joe's future creditors since the trust's assets do not belong to him. This could provide Joe security should he decide to start a new business venture.

For this technique to work, the company's nonstatutory stock options would have to be transferable to a trust. Stock option plans often do not permit such transfers. By definition, ISOs must be owned by the employee; therefore, they cannot be transferred to a trust.

Conclusion

Stock options are powerful incentives with potentially huge payoffs, provided the employee understands how his or her particular company plan works. For start-ups with relatively small spreads and a readily ascertainable value, the non-statutory stock option, with immediate vesting, is probably the best alternative. Be sure to exercise the option once the spread becomes taxable to you. To obtain the maximum capital gain, you must hold the stock for at least 12 months.